6.5 Compare and Contrast Variable and Absorption Costing

Variable Costing Versus Absorption Costing Methods

The difference between the absorption and variable costing methods centers on the treatment of fixed manufacturing overhead costs. Absorption costing “absorbs” all of the costs used in manufacturing and includes fixed manufacturing overhead as product costs. Absorption costing is in accordance with GAAP, because the product cost includes fixed overhead. Variable costing considers the variable overhead costs and does not consider fixed overhead as part of a product’s cost. It is not in accordance with GAAP, because fixed overhead is treated as a period cost and is not included in the cost of the product.

Deferred Costs

Absorption costing considers all fixed overhead as part of a product’s cost and assigns it to the product. This treatment means that as inventories increase and are possibly carried over from the year of production to actual sales of the units in the next year, the company allocates a portion of the fixed manufacturing overhead costs from the current period to future periods.

Carrying over inventories and overhead costs is reflected in the ending inventory balances at the end of the production period, which become the beginning inventory balances at the start of the next period. It is anticipated that the units that were carried over will be sold in the next period. If the units are not sold, the costs will continue to be included in the costs of producing the units until they are sold. Finally, at the point of sale, whenever it happens, these deferred production costs, such as fixed overhead, become part of the costs of goods sold and flow through to the income statement in the period of the sale. This treatment is based on the expense recognition principle, which is one of the cornerstones of accrual accounting and is why the absorption method follows GAAP. The principle states that expenses should be recognized in the period in which revenues are incurred. Including fixed overhead as a cost of the product ensures the fixed overhead is expensed (as part of cost of goods sold) when the sale is reported.

For example, assume a new company has fixed overhead of $12,000 and manufactures 10,000 units. Direct materials cost is $3 per unit, direct labor is $15 per unit, and the variable manufacturing overhead is $7 per unit. Under absorption costing, the amount of fixed overhead in each unit is $1.20 ($12,000/10,000 units); variable costing does not include any fixed overhead as part of the cost of the product. Figure 6.11 shows the cost to produce the 10,000 units using absorption and variable costing.

Figure 6.11 Finished Goods Inventory under Absorption and Variable Costing. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Assume each unit is sold for $33 each, so sales are $330,000 for the year. If the entire finished goods inventory is sold, the income is the same for both the absorption and variable cost methods. The difference is that the absorption cost method includes fixed overhead as part of the cost of goods sold, while the variable cost method includes it as an administrative cost, as shown in Figure 6.12. When the entire inventory is sold, the total fixed cost is expensed as the cost of goods sold under the absorption method or it is expensed as an administrative cost under the variable method; net income is the same under both methods.

Figure 6.12 Income Statement When the Entire Inventory Is Sold. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Now assume that 8,000 units are sold and 2,000 are still in finished goods inventory at the end of the year. The cost of the fixed overhead expensed on the income statement as cost of goods sold is $9,600 ($1.20/unit × 8,000 units), and the fixed overhead cost remaining in finished goods inventory is $2,400 ($1.20/unit × 2,000 units). The amount of the fixed overhead paid by the company is not totally expensed, because the number of units in ending inventory has increased. Eventually, the fixed overhead cost will be expensed when the inventory is sold in the next period. Figure 6.13 shows the cost to produce the 8,000 units of inventory that became cost of goods sold and the 2,000 units that remain in ending inventory.

Figure 6.13 Cost of Goods Sold and Ending Inventory with the Absorption and Variable Costing Methods. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

If the 8,000 units are sold for $33 each, the difference between absorption costing and variable costing is a timing difference. Under absorption costing, the 2,000 units in ending inventory include the $1.20 per unit share, or $2,400 of fixed cost. That cost will be expensed when the inventory is sold and accounts for the difference in net income under absorption and variable costing, as shown in Figure 6.14.

Figure 6.14 Net Income under Absorption and Variable Costing When Ending Inventory Remains. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Under variable costing, the fixed overhead is not considered a product cost and would not be assigned to ending inventory. The fixed overhead would have been expensed on the income statement as a period cost.

Advantages and Disadvantages of the Variable Costing Method

Variable costing only includes the product costs that vary with output, which typically include direct material, direct labor, and variable manufacturing overhead. Fixed overhead is not considered a product cost under variable costing. Fixed manufacturing overhead is still expensed on the income statement, but it is treated as a period cost charged against revenue for each period. It does not include a portion of fixed overhead costs that remains in inventory and is not expensed, as in absorption costing.

If absorption costing is the method acceptable for financial reporting under GAAP, why would management prefer variable costing? Advocates of variable costing argue that the definition of fixed costs holds, and fixed manufacturing overhead costs will be incurred regardless of whether anything is actually produced. They also argue that fixed manufacturing overhead costs are true period expenses and have no future service potential, since incurring them now has no effect on whether these costs will have to be incurred again in the future.

Advantages of the variable approach are:

• More useful for CVP analysis. Variable costing statements provide data that are immediately useful for CVP analysis because fixed and variable overhead are separate items. Computations from financial statements prepared with absorption costing need computations to break out the fixed and variable costs from the product costs.
• Income is not affected by changes in production volume. Fixed overhead is treated as a period cost and does not vary as the volume of inventory changes. This results in income increasing in proportion to sales, which may not happen under absorption costing. Under absorption costing, the fixed overhead assigned to a cost changes as the volume changes. Therefore, the reported net income changes with production, since fixed costs are spread across the changing number of units. This can distort the income picture and may even result in income moving in an opposite direction from sales.
• Understandability. Managers may find it easier to understand variable costing reports because overhead changes with the cost driver.
• Fixed costs are more visible. Variable costing emphasizes the impact fixed costs have on income. The total amount of fixed costs for the period is reported after gross profit. This emphasizes the direct impact fixed costs have on net income, whereas in absorption costing, fixed costs are included as product costs and thus are part of cost of goods sold, which is a determinant of gross profit.
• Margins are less distorted. Gross margins are not distorted by the allocation of common fixed costs. This facilitates appraisal of the profitability of products, customers, and business segments. Common fixed costs, sometimes called allocated fixed costs, are costs of the organization that are shared by the various revenue-generating components of the business, such as divisions. Examples of these costs include the chief executive officer (CEO) salary and corporate headquarter costs, such as rent and insurance. These overhead costs are typically allocated to various components of the organization, such as divisions or production facilities. This is necessary, because these costs are needed for doing business but are generated by a part of the company that does not directly generate revenues to offset these costs. The company’s revenues are generated by the goods that are produced and sold by the various divisions of the company.
• Control is facilitated. Variable costing considers only variable production costs and facilitates the use of control mechanisms such as flexible budgets that are based on differing levels of production and therefore designed around variable costs, since fixed costs do not change within a relevant range of production.
• Incremental analysis is more straightforward. Variable cost corresponds closely with the current out-of-pocket expenditure necessary to manufacture goods and can therefore be used more readily in incremental analysis.

While the variable cost method helps management make decisions, especially when the number of units in ending inventory fluctuates, there are some disadvantages:

• Financial reporting. The variable cost method is not acceptable for financial reporting under GAAP. GAAP requires expenses to be recognized in the same period as the related revenue, and the variable method expenses fixed overhead as a period cost regardless of how much inventory remains.
• Tax reporting. Tax laws in the United States and many other countries do not allow variable costing and require absorption costing.

Advantages and Disadvantages of the Absorption Costing Method

Under the absorption costing method, all costs of production, whether fixed or variable, are considered product costs. This means that absorption costing allocates a portion of fixed manufacturing overhead to each product.

Advocates of absorption costing argue that fixed manufacturing overhead costs are essential to the production process and are an actual cost of the product. They further argue that costs should be categorized by function rather than by behavior, and these costs must be included as a product cost regardless of whether the cost is fixed or variable.

The advantages of absorption costing include:

• Product cost. Absorption costing includes fixed overhead as part of the inventory cost, and it is expensed as cost of goods sold when inventory is sold. This represents a more complete list of costs involved in producing a product.
• Financial reporting. Absorption costing is the acceptable reporting method under GAAP.
• Tax reporting. Absorption costing is the method required for tax preparation in the United States and many other countries.

While financial and tax reporting are the main advantages of absorption costing, there is one distinct disadvantage:

• Difficulty in understanding. The absorption costing method does not list the incremental fixed overhead costs and is more difficult to understand and analyze as compared to variable costing.

Comparing the Operating Income Statements for Both Methods Assuming No Ending Inventory in the First Year, and the Existence of Ending Inventory in the Second Year

In order to understand how to prepare income statements using both methods, consider a scenario in which a company has no ending inventory in the first year but does have ending inventory in the second year. Outdoor Nation, a manufacturer of residential, tabletop propane heaters, wants to determine whether absorption costing or variable costing is better for internal decision-making. It manufactures 5,000 units annually and sells them for $15 per unit. The total of direct material, direct labor, and variable overhead is $5 per unit with an additional $1 in variable sales cost paid when the units are sold. Additionally, fixed overhead is $15,000 per year, and fixed sales and administrative expenses are $21,000 per year.

Production is estimated to hold steady at 5,000 units per year, while sales estimates are projected to be 5,000 units in year 1; 4,000 units in year 2; and 6,000 in year 3.

Under absorption costing, the ending inventory costs include all manufacturing costs, including overhead. If fixed overhead is $15,000 per year and 5,000 units are manufactured each year, the fixed overhead per unit is $3:

The projected income statement using absorption costing is shown in Figure 6.15:

Figure 6.15 Outdoor Nation’s Income Statement Using Absorption Costing. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

In variable costing, the fixed overhead is not included in the cost of goods sold even if it relates to manufacturing. As a result, the net income under variable costing differs from absorption costing by the same amount as inventory differential. The projected income under variable costing is shown in Figure 6.16:

Figure 6.16 Outdoor Nation’s Income Statement Using Variable Costing. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

The difference between the methods is attributable to the fixed overhead. Therefore, the methods can be reconciled with each other, as shown in Figure 6.17.

Figure 6.17 Outdoor Nation’s Reconciliation of Net Incomes. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Each method results in different amounts for net income when the inventory amounts change. More specifically, the effects on income are:

• Sales and Production equal. When a company sells the same quantity of products produced during the period, the resulting net income will be identical whether absorption costing or variable costing is used. When sales equals production, all manufacturing costs are accounted for in net income, and none of the costs are waiting in finished goods inventory to be recognized in a future period. Remember, with absorption costing, all manufacturing costs are added to the cost of the product during the work in process phase; thus, as the goods are sold, all costs have been accounted for. With variable costing, only the variable costs or production are added to the cost of the product during the work in process phase, and the fixed costs are expensed in the period in which they are incurred. Thus, in the example where sales and production are equal, all costs have been accounted for since all of the produced inventory has moved through cost of goods sold. This means that net income under absorption costing would be the same as net income under variable costing.
• Sales less than Production. When a company produces more than it sells, net income will be less under variable costing than under absorption costing. In this scenario, there will be a buildup, or an increase, in inventory from the beginning of the period to the end of the period. Under variable costing, fixed manufacturing costs are still in the finished goods inventory account. But under absorption costing, those fixed costs have been expensed during the current production period and thus have reduced net income.
• Sales greater than Production. When a company sells more than it produces during the current period, this indicates it is selling goods produced in a prior period. This will result in net income under variable costing being greater than under absorption costing. With absorption costing, all manufacturing costs are captured in the finished goods inventory account, and as those goods are sold, those costs become expenses. Selling items that were produced in a prior period defers the recognition of the costs of those products until the future period in which they are sold. Variable costing results in all of the variable costs associated with the sold products being in the current period net income, but only the current period fixed expenses would be included in the current period net income. The fixed expenses associated with the items produced in a prior period were recognized in the period in which they were incurred, not the period in which the products are sold. This results in fewer expenses and therefore greater income with the variable cost method.
• Effect of differences in Sales and Production Long Term. The differences between net income generated under absorption costing and variable costing will be almost zero over the long run, as all costs associated with the production of goods will eventually be recognized in net income. The use of absorption versus variable costing creates more of a timing issue for the recognition of fixed expenses, and this is why net income would vary from period to period under the two methods but in the long run would not. In addition, absorption costing does allow for manipulation of income by managers through overproduction. Increasing production at year-end results in a higher net income than if the additional goods had not been produced, since increasing the number of units decreases the fixed cost per unit. Under absorption costing, these fixed costs follow the units produced and do not become a part of cost of goods sold until they are sold. Instead, a portion of the fixed costs is in the inventory accounts. Why would a manager want to manipulate income by overproducing? If the manager’s annual bonus or other compensation is linked to net income, then the manager may be motivated to overproduce in order to increase the potential for or the amount of a bonus. If the level of sales remain constant while manipulating the production level, such an action would increase the company’s expenses (including the amount of bonus) while not increasing its revenue. Barring any other justification for the increase in production, such an action by the manager would typically be considered an ethical violation, since the manager’s actions would be in the manager’s best interests, but contrary to the best interests of the company.